Wednesday, January 9, 2013

Would Bernanke accept a trillion dollar platinum coin?

The idea behind the trillion dollar platinum coin goes something like this. According to law, President Obama is permitted to take an ounce of platinum, which is worth around $1,500 in the market, and mint it into a collector's coin that says $1 trillion on its face. Obama then heads off to the Federal Reserve and deposits the coin at face value, his $1,500 worth of platinum having been exchanged for $1 trillion worth of fresh Fed deposits.

What is being exploited here is the difference between a collector coin's intrinsic value and its legal tender face value. Anyone who has collected American Eagle's will be aware of this difference. On its face, an Eagle is worth $50. But the coin's intrinsic value due to its gold content is well over $1600.

Do Eagle's pass at their face value or at intrinsic value? Head on over to the US Mint and you'll see that the Mint is selling $50 Eagles at their intrinsic price of $1,900 or so. Coin dealer American Gold Exchange is hocking 1 oz Eagles for $1750. Aren't the Mint and and American Gold Exchange breaking the law in selling coins so far from face value? Not really. Legal tender laws stipulate the sorts of payment media required in the discharge of debt obligations. In selling collectors coins in retail spot transactions, the Mint isn't engaged in the activity of discharging debts. Nor is American Gold Exchange.

Think about the implications of requiring coin dealers and the US Mint to sell Eagles at face value to all comers. Both would be providing the world with the a great risk-free arbitrage opportunity—and destroying their balance sheet in the process.

Here's another interesting anecdote about collector's coins circulating (or not) at face value. From 1997 to 2003 Robert Kahre, a resident of Las Vegas and owner of 6 construction companies, ran a scheme in which he paid wages with gold eagles at their legal tender face value. Rather than hiring someone for say $50,000 a year payable by check, Kahre paid with 45 ounces of Eagles with a total face value of $2,250 or so. Their declared income of $2,250 was so low that Kahre's workers didn't have to report their income to the IRS. At the same time, Kahre saved on payroll tax. Win-win. Except for the IRS. In May 2003, Kahre's businesses were raided by the tax authorities. Kahre was at first acquitted in 2007, but in 2009 he was found guilty of tax evasion and sent to prison.

The implications of the Kahre case are that despite what's said on their face, collectors coins pass at intrinsic value in the US.

The ability, indeed requirement, to ignore a collector coin's face value when engaging in transactions with these coins is a matter of common-sense self-preservation. If private coin shops like American Gold Exchange, the US Mint, or the IRS were required to let eagles pass at face value they would all suffer tremendous losses. Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt. Face value on collectors coins is merely symbolic, not obligatory.

With the rest of the US already passing collector coins at their intrinsic value, why would Ben Bernanke be expected to accept a platinum collector coin worth $1,500 at its face value of $1 trillion? He has no obligation to do so. As I pointed out, legal tender refers to the types of media that can be used to discharge debts, and Bernanke is not indebted to Obama in any way. All he does is administer the Treasury's account at the Fed.

Nor can Bernanke choose to forgo self-preservation. Section 16.2 of the Federal Reserve Act obligates him to protect the Fed's balance sheet by stipulating the rules concerning Federal Reserve note collateralization. The Act requires that all notes must be backed by

collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application... In no event shall such collateral security be less than the amount of Federal Reserve notes applied for.

This means that notes cannot be backed by an insufficient amount of collateral security. There is a long history behind section 16.2. I've discussed it before here and here. 16.2 has been liberalized over the decades. In the old days, only a small range of assets could stand as collateral, but now almost any asset can back the note issue. Nevertheless, the 16.2 requirement for sufficientquantity of security remains. If a collector coin's market value is only $1,500, then Section 16.2 presumably prevents Bernanke from depositing the coin in exchange for anything over $1,500 in Fed notes and deposits. Any larger amount of notes and deposits applied for and the coin fails the collateral test.

The case could be made that Bernanke would accept the trillion dollar coin if it were to represent a binding debt of the government to repay the $1 trillion loan. But in this form the coin is no more than a bond or promissory note. Instead of being written on paper, the promise is embossed on platinum. Bernanke can't directly accept government debt, no matter if its inscribed on platinum, paper, or a mere digital entry. He can only bring government debt onto his balance sheet after the market has already purchased it. These limits can be found in sections 13 and 14 of the act. Section 13, which governs the Fed's lending powers, does not give the Fed power to lend to the government, while section 14, which governs open market purchases, only allows the Fed to purchase government bonds on the open market.

Of course, we can speculate about the possibility of Bernanke accepting the trillion dollar coin until we turn blue. We only really know what he'd do when the time actually comes. Bernanke might accept the trillion dollar coin at face value, but he'd surely have both tradition and law on his side in questioning his obligation to do so. However, laws and conventions often bend and morph when circumstances dictate. The Bear Stearns transaction via Maiden Lane I and the AIG bailout via Maiden Lane II and III somehow went through, despite what would seem to be explicit warnings against such actions in the Federal Reserve Act.
Until it gets minted, I've got to hand it to the Beowulf, the originator of the trillion dollar coin idea, in having created what seems to be the econ blogosphere's most influential idea of the New Year.

[Update: In the comments with Bill W., I mentioned another bit of legalese indicating that the Fed needn't accept coin from either the government or a member bank. See section 13.1 of the Federal Reserve Act: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.” More evidence that Bernanke can say no to a government deposit request. May≠must.]

16 comments:

Though wouldn't the executive branch be in violation of the Constitution by usurping congrssional power of "fix[ing] the Standard of Weights and Measures" by assigning a value of 1 trillion dollars to a new platinum coin?

Plus, doesn't Congress have to approve what is going to be minted on the coin?

Yes, that's certainly an issue. That's probably why Section 16.2 was written into the Act in the first place... to prevent the Fed from acquiring overvalued assets with no resale value. After all, if the Fed ever needed to contract the note issue, it would be tough to do so by selling a $1500 coin, or any other over-valued asset for that matter.

"Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt."

It's just like the government handing out $48 per coin. It increases the national debt but nobody goes bankrupt.

But it's strange for anything but a Fed obligation be legal tender, because we normally use the banking system to make payments. If banks can't deposit the legal tender at the Fed, then they won't allow their customers to deposit it. And if you can't deposit it at your bank, then you can't spend it. You can't even use it to pay taxes.

(How did the old U.S. Notes work? I've never really understood those things).

There must be some sort of limitation on the issuance of US notes, otherwise they wouldn't be advocating a platinum coin. This link says that the issue was capped at $382m in 1874.

"If banks can't deposit the legal tender at the Fed, then they won't allow their customers to deposit it. And if you can't deposit it at your bank, then you can't spend it."

Private bank deposits don't have legal tender status (at least in Canada), but customers can deposit cheques at their bank. I don't think Fed acceptance, or legal tender, are prereqs for "spendability". But I agree that the Fed's refusal to accept deposit of a platinum coin at face value will prevent banks and banking customers from ever accepting it at face value. It'll trade by weight, not by tale.

Wouldn't they say no? In the Kahre case the IRS refused to let eagles circulate at face b/c it hurt them, why would they accept $50 face gold coins worth just $2?

As an aside, I stumbled into this interesting article last night. It applies to Canada, not the US. In any case, in Canada banks and institutions can refuse to accept non-circulating legal tender in any transaction (NCLT = collectors coins). See Royal Mint FAQ. I'm not sure whether the same features appear in US law. But it would be very difficult to carry out the platinum coin scheme up here.

The Treasury owes the Fed a huge amount of money--all of the treasury bonds and notes that the Fed owns.

As these come due, the Treasury pays the Fed for them, and the Fed buys new ones to replace the old ones.

Suppose the Treasury minted $1 coins to pay the Fed for the bonds as they come due?

In fact, the Treasury could pay all of its bills with coins. When Boeing sends the invoice for the jet fighters, the Treasury pays with piles of newly minted $1 coins. They are legal tender for all debts private and public.

Of course, Boeing might decide to never sell more jet fighters to the U.S. government again (doubtful.)

Banks today accept deposit of dollar coins. (I think they have to. There is a provision of law to allow their use.) Can the Fed refuse to accept deposits of coins from member banks? Maybe, I don't know for sure. But the Fed does accept them for deposit.

Anyway, while a $1 trillion coin might not work out too well, minting $100,000 coins out of 1/10 of an ounce of platinum would probably work out OK for the Treasury to pay off the bonds and bills the Fed owns as they come due.

As those bonds and bills are paid off, the national debt falls below the limit, and the Treasury can sell more bonds and bills and pay for things, like jet fighters from boeing.

Or, of course, the Treasury could mint and pay for jets with some $100 million platinum coins.

Just considering these possibilities suggest to me that rather than require the Treasury to mint a variety of high denomination platininum coins and spend them, the Fed would just accept the trillion dollar coin just like they accept $1 coins, quarters, dimes, and pennies today.

Of course,today, the Fed orders up the coins and pays the Fed for them. The proposal here is that the Treasury sends over a really big coin that the Fed didn't ask for, and the Fed pays for it just like the ones it requested.

"Suppose the Treasury minted $1 coins to pay the Fed for the bonds as they come due? In fact, the Treasury could pay all of its bills with coins. When Boeing sends the invoice for the jet fighters,"

Given legal tender laws, that seems the proper way to go about it. Or, when the t-bills the People's Bank of China are redeemed, the Treasury could pay the Chinese with these platinum tokens. Would the Chinese ever choose to buy t-bills again? Sounds like a gamble. My guess is that after the platinum coin plan is enacted, those doing business with the government would try to work clauses into subsequent contracts requiring settlement in some other medium, thereby skirting legal tender laws that require them to accept the coin.

"Banks today accept deposit of dollar coins."

I don't know the rules on this. In Canada, banks don't have to accept non-circulating legal tender like platinum coins. Still not sure about the US.

"Can the Fed refuse to accept deposits of coins from member banks? Maybe, I don't know for sure. But the Fed does accept them for deposit."

Section 13.1 of the Federal Reserve Act says: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.” ......May≠must.

"the Fed would just accept the trillion dollar coin just like they accept $1 coins, quarters, dimes, and pennies today."

There is a tension here since the Fed is also required to protect its balance sheet. I'm not sure what would give first. The Fed certainly has grounds for push-back.

"Neither the Treasury Department nor the Federal Reserve believes that the law can or should be used to facilitate the production of platinum coins for the purpose of avoiding an increase in the debt limit," said Treasury spokesman Anthony Coley in a statement.